Firstly, congratulations on discovering the Wheel Strategy and taking the first step to learn more! 

Back in 2017, there weren’t many complete guides available about Wheel Strategy. You will need to gather information from various websites to understand it better. Nowadays, there are many more people supporting and advocating this strategy.

So what is so amazing about the strategy?

As you know, “buy low, sell high” is the mantra of successful investors, but it needs a powerful strategy to execute it consistently.

Indeed, the Wheel Strategy is one of those strategies that lets you methodically “buy low, sell high.”

When done right, it’s actually safer than the simple buy and hold approach in the stock market.

The main challenge when starting options trading is getting the right knowledge.

If you’re already buying and selling stocks, moving to options trading shouldn’t be too difficult. You should already know the basics of setting up a broker account, funding it, and placing limit orders.

But if you haven’t gotten to that point yet, it’s really important to learn these basics first before you start options trading.

Part 1: Options Fundamentals

Although you might feel compelled to jump in headfirst and learn as you go, becoming a successful options trader requires a solid understanding of key options fundamentals before delving into any specific strategies.

In this article, we’ll delve into the fundamentals of options, laying the groundwork for a deeper understanding of the Wheel Strategy.

What Exactly Are Options?

First and foremost, an option is a financial agreement between two parties. The value of this agreement depends on the underlying assets that both parties have decided upon. For instance, a stock option gets its value from the price of the stock it is associated with.

Explaining options using an analogy, it’s like comparing them to an insurance company.

Options Buyer Perspective

Options buyers are like “insurance customers” who want to insure against specific events, such as disabilities or serious health conditions. They pay a premium to transfer the risk to the insurance company.

Similarly, a compelling reason for individuals to buy options is to protect themselves from losing money in the stock market.

Imagine you own a stock called X currently trading at $33, and you’re worried that its price might drop below $30.

To safeguard against that possibility, you can purchase something called a “put option” contract. The money you paid for this contract is known as the “premium”.

This contract gives you the right to sell X at the agreed price of $30 (known as the strike price), but here’s the catch – you have this right only until a specific date, let’s say one month from now.

Now, let’s say by that date the stock price of X actually falls to $28. Since you have the put option, you can still choose to sell your stock at $30, even though its actual value is only $28 at that moment.

This way, you avoid bigger losses that you might have faced if you hadn’t used the put option. It’s like having a safety net for your investment, just in case things go south.

Options Seller Perspective

Conversely, options sellers are like the “insurance company”. They receive premiums from the buyers but are obligated to make ‘payouts’ if certain conditions occur within a set time frame.

Let’s compare selling options to selling stocks. When you sell options, you’re taking a risk and agreeing to buy stocks at a set price by a certain date.

In return for taking this risk, you receive some money upfront paid by the options buyer, which is called a premium.

For instance, if stock X is currently trading at $33, and you’re the options seller, you believe that the stock price won’t drop below $30 in 1 month. Even if it does fall below $30, you’re still okay with buying the stock at that price.

So you sold a “put option” for a stock X, which will expire in 1 month. The deal is that if the stock price is higher than $30 when the month is up, you get to keep the premium earned from selling the option. But, if the stock price drops to $30 or lower (e.g. $28), you have to buy the stock at $30 per share.

Regardless of whether the stock price goes up or down, you still get to keep the premium you made when you sold the option.

Put vs. Call Options

In the previous section, we discussed put options. However, there’s another type of option called “call options”. Here is a summary outlining the perspectives of both buyers and sellers for put and call options:

How Many Shares Does 1 Option Contract Represent?

Another very important point to know about options is that each contract equates to 100 shares of the underlying asset.

But why is this important?

Suppose you want to sell a put option for a company like INTC (Intel Corporation). When you do this, you agree to potentially buy 100 shares of INTC stock at a specific price, let’s say $30 per share. To show that you can fulfill this agreement if needed, you need to set aside $3000 in cash for each option contract you sell. This way, you have enough money to buy the shares if the option is exercised by the buyer.

If you have enough money in your brokerage account to buy the stock if the option is exercised, it’s called a “cash-secured” trade. This means you can purchase the shares directly without needing to borrow money on margin.

Every Options Contract Has An Expiration Date

As you’ve seen in the previous examples, options contracts have a specific expiration date and do not last indefinitely. Typically, this expiration date falls on Fridays. However, if the Friday happens to be a holiday, the expiration date is moved to the Thursday before the holiday.

If the option is not exercised before the expiration date, the person who bought the option loses the premium they paid for it. On the other hand, the person who sold the option gets to keep the premiums they received, which becomes their profit.

Note: For option contracts in the United States, the buyer can choose to exercise the contract (i.e. sell or buy the underlying asset at strike price for put and call options respectively) anytime before the expiration date.

What Are The Factors Influencing Option Prices?

Finally, it’s essential to know some of the things that impact the price of option contracts. Here are the four main factors:

1. Time value (time remaining until the contract expires)
2. Strike price
3. Current price
4. Price volatility

Out of these factors, it’s important to focus on two specific ones: time value and price volatility. That’s because when you’re choosing which asset, price, and expiry date to use for your options, you’ll often keep these two factors in mind. They play a significant role in your decision-making process.

Time Value

As the expiration date approaches, the time value of an option decreases, and time decay accelerates. This occurs because there is less time available for an investor to potentially earn a profit from the option.

Price Volatility

When the stock trades steadily with small price changes, it’s more predictable, and the option seller feels more certain that there won’t be big price swings for the stock. So, the options are considered less risky, and their value will be lower.

But, if the stock is very volatile and has big price swings, it’s harder to predict what will happen by the option’s date. This means more risk for the seller, so they will ask for a higher price for the option to match the risk they are taking.

Grasping these fundamental options concepts will enhance your understanding, making it easier to follow the strategy discussed in the next section.

Please note that this guide is just a brief introduction to options trading, designed to help you get started. I highly recommend diving deeper into the subject with additional resources.

If you need a recommendation, one of my favorite books on the topic is The High Probability Options Trader by Marcel Link.

Part 2: The Wheel Strategy Explained

Now it is time to talk about the exciting part, which is the strategy itself.

The Wheel Strategy is a method of trading options that involves consistently executing just two kinds of trades - a cash-secured put and a covered call. 

The term "cash-secured" means that you set aside enough cash to buy the stock at the strike price if the option is exercised.

Similarly, a call is considered "covered" when you already own the underlying stock.

How It Works:

1. Sell Cash-Secured Put:

   • You sell a put option on a stock* you like. 
   • If the stock price stays above the strike price, you keep the premium.
   • If the stock price drops below the strike price, you buy the stock at that price.

2. Own the Stock:

   • Now, you own the stock at a discount.
   • Next, you sell a covered call on this stock or ETF.

3. Sell Covered Call:

   • You sell a call option on the stock you now own.
   • If the stock price stays below the strike price, you keep the premium and the stock.
   • If the stock price goes above the strike price, your stock is sold at that price, and you earn the premium plus any profit from the stock price increase.

4. Repeat the Cycle:

   • After selling the stock, you go back to Step 1 and repeat the process.

*Can be individual companies or Exchange-Traded Funds (ETFs)

Illustration

Imagine you like the fundamentals of Alphabet (GOOGL) and decided to apply the Wheel Strategy. The stock is currently priced at $160.

• Step 1: Sell a GOOGL $155 put for $2 premium.

  • If it stays above $155, you keep $2.
  • If it drops below $155, you buy it at $155 but effectively paid $153 (after premium).

• Step 2: Own GOOGL at $155, sell a $160 call for $2 premium.

  • If it stays below $160, you keep the stock and the $2.
  • If it rises above $160, you sell it at $160 and make $7 profit ($5 from the price increase + $2 premium).

• Step 3: Sell another put or call on GOOGL, repeating the cycle.

As you can see, this strategy allows you to generate income whether the stock moves up, down, or sideways, and potentially acquire shares at a discount.